How Option Premiums are Determined

An option premium is determined the same way futures prices are determined, through active open out-cry competition between buyers and sellers. Several variables influence an options premium. An options exercise price, or the relationship between the exercise price and the current market price of the underlying commodity contract, is the primary determinant of premium.

An option that is above its strike price is known as an " in-the-money " option and commands a higher premium than an option that is not yet reached the strike price, known as an "out-of-the-money" option. If for example, a gold contract is currently trading at $395 an ounce, a put option conveying the right to sell gold at $420 an ounce is more valuable, with a higher premium, than a put option that has the right to sell gold at $400 an ounce.

An option with a long period of time remaining until expiration commands a higher premium than an option with a short period of time remaining until expiration because it has more time, or " time value " in which to become profitable. Options are a wasting, or an eroding asset. Its time value declines as it approaches expiration.

The greater the volatility of the underlying commodity contracts the higher the option premium. Reason being that In a volatile market, the option stands a greater chance of becoming profitable to exercise

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